International Tax Reform For Dummies

Ok, ok…I understand that my title borders on an oxymoron. We can no more expect to effectively present “International Tax for Dummies” then we could “Quantum Physics for Dummies” or “Dennis Miller Monologues for Dummies.” But we’ve got to try. Why?

Because yesterday, Senate Finance Committee Chairman Max Baucus (D-Mont) formally released a plan for fixing the current international tax system, and news regarding the proposal is everywhere today. Chances are, if you ply your trade in the accounting world someone just might ask you what you think of it. And you don’t want to sound uninformed, do you?

So let’s start by establishing this little nugget: the international tax regime is a system that definitely needs fixing.

Currently, the income earned by U.S. corporations is taxed at a maximum of 35%, regardless of where in the world it is earned. The income earned by foreign corporations from U.S. sources is also subject to U.S. tax. In general, these two concepts are not problematic.

The problem, however, is how the U.S. treats the foreign income earned by foreign subsidiaries of U.S. corporations. This income is taxed under what is commonly referred to as a “deferral” system. As explained in greater detail below, this means that the income earned by the foreign subsidiary is generally not subject to U.S. tax until it is repatriated to the U.S. in the form of a dividend. Couple this with the fact that the U.S. corporate rate of 35% is currently the highest of any developed nation, and as you might guess, this deferral system provides tremendous incentive for U.S. companies to move foreign operations offshore and then avoid bringing back those offshore profits, depriving the U.S. government of much-needed cash and U.S. taxpayers of much-needed jobs. At present, it is anticipated that as much as $2 trillion of profits are currently housed offshore in foreign subsidiaries of U.S. corporations. Imagine if that $2 trillion were back in the U.S.? The White House could finally afford an operable website. HI-YO!!!!!!!!!!!!!!!

Perhaps the only area in all of the tax law that currently has bipartisan support is the notion that this deferral system has to go. But as you might imagine, this is where any agreement between Republicans and Democrats end.

Not to brush with too broad of a stroke, but Republican lawmakers generally support a “territorial” system, while their Democrat counterparts, led by President Obama, favor a “worldwide” system that represents almost the polar opposite of a territorial system.

Yesterday, however, Senator Baucus shook things up a bit by offering a system with elements of both a worldwide and territorial system. But what does any of this really mean? What is a “worldwide” and “territorial” international system? How do they compare to our current “deferral system” system? How would the Baucus recommendation marry the differnt concepts? And perhaps most importantly, how would any of these concepts change the way the U.S. currently taxes income earned by foreign subsidiaries of domestic corporations?

To illustrate, let’s take a simple fact pattern:

X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources.

How is Foreign Co.’s income taxed by the U.S. under either:

1) The current “deferral” international tax system?

2) The “territorial” tax system favored by the Republicans?

3) A more expansive “worldwide” tax system as proposed by President Obama?